Ideoblog

Explaining Jones

Why did counsel for the defendant in Jones v. Harris, the mutual fund fees case, abandon on oral argument the reasoning of the judge who had supported its position? Todd Henderson has a plausible explanation:

Easterbrook believes that litigation against advisors claiming excessive compensation is socially wasteful, and his opinion tries to do away with these cases in all but the most extreme cases. This Essay * * * exposes the reasons why none of the parties nor the mutual fund industry agree with Judge Easterbrook. Obviously the lawyers on both sides benefit from litigation, which he is trying to end, but more interestingly the mutual fund industry rationally prefers the small tax on its profits that the current regime generates over the risk that the Supreme Court or, worse, the Congress might make matters much worse. This case is therefore a classic example where the narrow interests of the parties are not informative of the right result. This Essay shows why the Supreme Court should consider the interests of investors over the lawyers and the funds before reinstating a legal regime under which the plaintiffs have never won and that serves no deterrent function.

But if the Court considers investors' interests, would it get reversed by Congress? Is there a scenario here in which the investors win? Doesn't seem that way.

A standard forms approach to mutual funds regulation

That's my take on Jones v. Harris for the Conglomerate Masters forum.  Tune in!

Update:  Here's William Birdthistle's ringside view of the oral argument.

More on paternalism and mutual funds

A couple of weeks ago I posted on the upcoming Supreme Court case of Jones v. Harris, which will decide an important issue of investment advisor fees, and which raises broader issues of mutual fund governance, behavioral law and economics, and the general question of whether consumers need to be protected from their judgment errors in competitive markets. I linked other posts on these issues by Steve Bainbridge, Dale Oesterle and William Birdthistle.

There's been a lot more writing on these issues. In particular, Josh Wright added his thoughts, including the following:

The basic economic point is that demonstrating that some consumers are systematically irrational alone says nothing about whether fees are likely anticompetitive or supra-competitive or about the strength of the economic logic that says you'd still get competitive outcomes.

Birdthistle responded and Wright replied:

Birdthistle makes two points: (1) that I rely on the same argument as Easterbrook (echoing Schwartz & Wilde) that the presence of irrational investors does not mean that we get inefficient outcomes because competition for the sophisticates on the margin protects the naifs — an argument that is wrong because in the mutual fund industry there is a "uniquely rigid segregation of sophisticated investors from unsophisticated — with the former buying one set of investments and the latter buying a very differently priced one — which neutralizes the possibility that sophisticated sentinels will protectively police for all"; and (2) that I'm the one playing fast and loose with burdens here since 36(b) of the Investment Company Act already exists, and so the burden lies on the price theorists to present evidence sufficient to override it * * *

Imagine a world where the fraction of investors exhibiting these biases is 1.  Or a more complicated world like the one Birdthistle contemplates with two different markets without interaction where the fraction of investors with biases in one market is 1 (the naive market) and 0 in the other (sophisticated market).  What happens to the naifs in these markets?  It still depends on ex ante competition.  Imagine that each seller knows ex ante that he can extract an extra 10% profit out of the buyer ex post (after lock-in) because of switching costs related to behavioral biases.  Indeed, sellers will in fact hold up the buyers ex post and extract those rents.  But a complete competitive analysis must also consider what happens to the ex ante competition for these naifs.  Some elements of competition occur ex ante and others ex post.  If competition between mutual funds is sufficiently vigorous then we will still get a zero profit equilibrium.  How will that occur?  Given that sellers know that they will increase profits 10% ex post, one expects competition between sellers to dissipate that 10% profits in various forms of ex ante competition.

Now 25 corporate law and finance professors, including yours truly, have filed an amicus brief in Jones. John Coates summarizes:

The scholars' amici curiae brief, filed in support of the defendant's position, (1) addresses misperceptions regarding competition in the mutual fund industry today, (2) reviews facts about the industry that demonstrate that competition for investors is now an important force that constrains mutual fund advisory fees, and (3) suggests that the Supreme Court, in articulating the legal standard applicable to an assessment of whether mutual fund advisory fees are excessive under Section 36(b) of the ICA, should specify that two sets of facts relating to competition and advisory fees should be considered: (a) evidence of competition for investors by funds similar to the type of fund at issue; and (b) evidence of the extent to which such competition constrains the fees charged by the adviser and approved by the fund's directors, and whether that competition is likely to produce fees similar to those generated by arm's-length bargaining. Information about competition, the brief suggests, should inform the decisions of independent directors, evaluating advisory fees in the first instance, and of courts in the event of a fee challenge.

Next up: William Birdthistle will present and defend his arguments in my Illinois Corporate Colloquium in September 21. Then, on November 2, the case is argued in the Supreme Court. I'll be talking about both right here.

Mutual funds and the new paternalism

Professor Bainbridge, the NYT and Dale Oesterle discuss the forthcoming Supreme Court opinion in Jones v. Harris, 527 F.3d 627 (7th Cir. 2008), a suit by Oakmark fund investors that the funds had overpaid their investment adviser. Dale says "This case will reaffirm or change existing practice and either result will have ripples across the governance of companies countrywide."

Prof B doubts the ripple effect, citing Langevoort, Private Litigation to Enforce Fiduciary Duties in Mutual Funds: Derivative Suits, Disinterested Directors and the Ideology of Investor Sovereignty, 83 Wash. U. L.Q. 1017, 1019 (2005), for the proposition that the two contexts differ because the efficient capital markets and the a market for control, the major constraints in the corporate world, do not

arguably operate[] with any power in the world of mutual funds. Because mutual funds are not traded in an organized market, arbitrage opportunities cannot work to keep prices in line with rational expectations. Mutual fund prices are simply the product of net asset value at the time of purchase or redemption. Insider compensation is largely based on assets as well, which creates the conflict rather than aligns insider-shareholder interests, and directors are typically paid all or mostly in cash. Institutional shareholder voice does not exist in the fund area, and there is no external market for corporate control at all because shareholders can only sell their shares back to the fund. Thinking about mutual funds by imagining them simply as a species of "corporations" in a way that is directly informed by contemporary corporate law theory is completely misguided.

The NYT highlights Posner's dissent in Jones, in which he noted that "executive compensation in large publicly traded firms often is excessive * * * because of the feeble incentives of boards of directors to police compensation" – despite the fact that Posner is "a conservative with libertarian leanings, and he is a leader of the law and economics movement associated with the University of Chicago." [I question the "libertarian leanings" part, but that's a subject for another post.]

But Judge Easterbrook dismissed the suit. He reasoned:

Today thousands of mutual funds compete. The pages of the Wall Street Journal teem with listings. People can search for and trade funds over the Internet, with negligible transactions costs. * * * Mutual funds rarely fire their investment advisers, but investors can and do "fire" advisers cheaply and easily by moving their money elsewhere. Investors do this not when the advisers' fees are "too high" in the abstract, but when they are excessive in relation to the results-and what is "excessive" depends on the results available from other investment vehicles, rather than any absolute level of compensation.

* * * New entry is common, and funds can attract money only by offering a combination of service and management that investors value, at a price they are willing to pay. Mutual funds come much closer to the model of atomistic competition than do most other markets. Judges would not dream of regulating the price of automobiles, which are produced by roughly a dozen large firms; why then should 8,000 mutual funds seem "too few" to put competitive pressure on advisory fees? A recent, careful study concludes that thousands of mutual funds are plenty, that investors can and do protect their interests by shopping, and that regulating advisory fees through litigation is unlikely to do more good than harm. See John C. Coates & R. Glenn Hubbard, Competition in the Mutual Fund Industry: Evidence and Implications for Policy, 33 Iowa J. Corp. L. 151 (2007) [see my discussion of this paper]

It won't do to reply that most investors are unsophisticated and don't compare prices. The sophisticated investors who do shop create a competitive pressure that protects the rest. See Alan Schwartz & Louis Wilde, Imperfect Information in Markets for Contract Terms, 69 Va. L.Rev. 1387 (1983). As it happens, the most substantial and sophisticated investors choose to pay substantially more for investment advice than advisers subject to § 36(b) receive. * * * When persons who have the most to invest, and who act through professional advisers, place their assets in pools whose managers receive more than Harris Associates, it is hard to conclude that Harris's fees must be excessive.

Harris Associates charges a lower percentage of assets to other clients, but this does not imply that it must be charging too much to the Oakmark funds. Different clients call for different commitments of time. Pension funds have low (and predictable) turnover of assets. Mutual funds may grow or shrink quickly and must hold some assets in high-liquidity instruments to facilitate redemptions. That complicates an adviser's task. Joint costs likewise make it hard to draw inferences from fee levels. Some tasks in research, valuation, and portfolio design will have benefits for several clients. In competition those joint costs are apportioned among paying customers according to their elasticity of demand, not according to any rule of equal treatment.

Federal securities laws, of which the Investment Company Act is one component, work largely by requiring disclosure and then allowing price to be set by competition in which investors make their own choices. Plaintiffs do not contend that Harris Associates pulled the wool over the eyes of the disinterested trustees or otherwise hindered their ability to negotiate a favorable price for advisory services. The fees are not hidden from investors-and the Oakmark funds' net return has attracted new investment rather than driving investors away. As § 36(b) does not make the federal judiciary a rate regulator, after the fashion of the Federal Energy Regulatory Commission, the judgment of the district court is affirmed.

In 2004 I took a position like the one Easterbrook later took in Jones in discussing the mutual fund scandal du jour. See Do the Mutuals Need More Law? Regulation Magazine, Spring, 2004 at 14:

Mutual funds have won trillions of dollars in investments from consumers who chose funds over competing banks, insurers, and other financial service providers. Any problems came despite, or perhaps because of, 60 years of pervasive federal regulation. The first question we ought to ask, then, is do we really need more mutual fund laws — or just better enforcement of the ones we already have?

See also, to the same effect, Henry Manne, What Mutual Fund Scandal?, Wall St. J., Jan. 8, 2004, at A22.

So did Paula Tkac, writing in the WSJ. As I noted at the time:

Paula Tkac writing in today's WSJ that the follies with the SEC's mutual fund independent director rule * * *make this a good time to recognize that open-end mutual funds don't need such directors anymore than do "service-providers such as lawyers or automotive technicians."

Tkac notes that, since customers can withdraw funds at current net asset value, "mutual fund advisers have fewer opportunities to harm fund investors, and investors can do much more to protect themselves and discipline management than in a typical corporation." Also, mutual fund investors easily can "compare the services they receive, net of the fee paid, with those offered by other funds or alternative investment vehicles."

Nor are individual investors unsophisticated. After all, they promptly sold the funds like Putnam, Janus and Invesco that were involved in the mutual fund scandals and bought funds in families that had clean records." Tkac concludes that "there is reason to consider removing board oversight of fees. We might even contemplate eliminating the legal mandate to have mutual fund boards at all."

And even Don Langevoort was on board in the article discussed earlier, which I discussed at the time. Langevoort noted:

Mutual fund investments are products – no different, really, from health care, insurance, bank deposits, residential real estate and other important settings where consumers are often less than diligent. In fact, because of securities regulation and the sophistication of the financial media, the transparency in the mutual fund area is probably superior to that for most of those other important household decisions.

Langevoort argued that the fiduciary and consumer characterizations were inconsistent. But I was skeptical:

why not have state competition as to mutual fund governance, as we do about corporate law, with federal regulation limited to disclosure. The states could recognize the differences between corporations and mutual funds and legislate accordingly, including as to rules for dismissal of derivative suits. Mutual funds would still be products, but the product would include these state governance rules.

The NYT article makes much of briefs filed by Ayres, Litan, and Mason, and by the federal government, highlighting investors' judgment errors and lack of information, and the difference between the deal ordinary investors get and what investment advisors charge pension funds. But as Easterbrook's opinion quoted above noted: "Different clients call for different commitments of time. Pension funds have low (and predictable) turnover of assets."

The NYT article concludes:

When public sentiment, economic research and even Judge Posner argue for more vigorous judicial examination of whether compensation is fair, the Supreme Court may just agree.

The ramifications of this case potentially extend well beyond the Court's holding, whichever way it goes. If consumers of mutual funds can be counted on to judge these products, why not other, less sophisticated products? Or why not corporations, as I asked in my post on the Langevoort article:

Next question: how is this different from corporate law? Not because of investor judgment biases, because surely investors in corporate stock suffer from analogous defects – indeed, probably more, because they're investing in individual stocks rather than rationally buying the market. The difference goes to the redemption mechanism, but this is an endogenous governance rule – one of the many variations one might expect among different investments.

Bottom line: Mutual funds are like corporations.  They are both products.  And they are both fiduciary relationships.  Neither should be subject to federal regulation of internal governance.

On the other hand, I suspect that in this day and age the Supreme Court will side with Posner. Such a decision would be a symptom and signal of our sharp turn toward paternalism in everything from complex finance to corporate governance to the simplest products.

Update:  William Birdthistle, who's been leading the charge for reversal in Jones, responds.

Obama proposes SOX II

Here's a nifty summary, and Bainbridge's early critique.

I haven't evaluated the proposal closely, and won't be able to for awhile because I'm about to get out of range for a couple of weeks. But I do have a few quick thoughts on particular elements of interest. 

First, we have to keep in mind that this isn't really a legislative package, but a kind of starting gun to let the intense lobbying begin.  It will be interesting to compare the proposal to the sausage that emerges at the other end of the grinder.

Second, since we're about to embark on SOX II, wouldn't it be useful to look again at what happened with SOX I?  Here's Butler and my analysis.  At the end of our book we have some suggestions for regulatory humility, such as optional provisions and sunsetting.  I fear that in the end we will find that we learned very little from the SOX debacle.

Third, the Obama proposal suggests (p. 13) requiring hedge fund registration under the Investment Advisers Act overseen by the SEC.  It also proposes that hedge funds be required to make reports on funds under management sufficient to indicate whether they pose a threat to financial stability. 

This is particularly misguided.  The best commentator on that is Houman Shadab.  See here and here.  The bottom line is that hedge funds are more a solution to problems of the financial system than a cause. 

The "systemic risk" argument is totally misguided.  As Jon Macey has noted, hedge funds actually combat systemic risk by, essentially, betting against the "system."  One way to make them part of the problem is to force enough disclosure that other financial institutions can follow them off any cliffs they seek to explore.  See Macey, PROMISES KEPT, PROMISES BROKEN 265-72(2008).

And what's with this regulation by the SEC?  Are we satisfied with the great job that agency did supervising Madoff?  See here (detailing the SEC's massive regulatory incompetence in Madoff) and here (suggesting that the SEC was actually Madoff's unwitting accomplice). 

Fourth, the proposal calls for (p. 40) "increased national uniformity through either a federal charter or effective action by the states." Butler and I show that this objective in insurance regulation is misguided and offer a better alternative.

Finally, let's keep in mind that the US is no longer alone in the world.  Regulatory overkill here could be a boon for places like Singapore and Hong Kong.

Hedge fund registration and Madoff's investors

Two years ago I noted:

the reason for the Donaldson rule [requiring hedge fund registration] was to protect entrenched interests from the competitive threat represented by hedge funds, not the investors in these funds.

Now Clusterstock provides some confirmation, and a warning about future regulation:

We've no doubt that the Bernie Madoff fiasco will increase calls for closer oversight of the hedge fund industry... Except it's worth pointing out that Madoff didn't run one of these much-maligned, unregistered hedge funds. He was registered with the SEC. Here's his latest 13-F, which looks perfectly normal.

What protections did Madoff clients get from that? Apparently, nada. Despite the fact that Madoff has been under suspicion for years, the SEC didn't do anything until the firm came clean itself. If anything, the fact that Madoff was registered with the SEC might've made clients more willing to place their money with him. Yeah, he's a little shady, but he's SEC-registered. So when they bring hedge fund managers up on the hill again to bring this topic up, hopefully someone will ask what SEC oversight is supposed to accomplish?

Update:  Apparently the SEC actually had information about the problems with Madoff in 1999 and did nothing (other than try to shut down legitimate market activity), while an investment advisor aggressively investigated and warned its clients.  Does this add up to evidence that we need a super-SEC?

The real problem with sovereign wealth investments

The WSJ’s Holman Jenkins discusses the real problem with sovereign wealth funds’ purchase of stakes in US firms:

[I]t would be unlike Congress to miss an opportunity to disapprove of wealthy foreigners in funny hats. Such a backlash would only exacerbate the real dilemma with sovereign funds: Are they smart money or dumb money, helping or hurting corporate efficiency? * * *

That sovereign investors might provide support for maladaptive corporatism is among the reasonable (as opposed to many unreasonable) fears about such funds, and we don't pooh-pooh those like BlackRock's Larry Fink who've recently given voice to it. But let's catch our breath. Non-aggressive, management-friendly ownership has already been the rule for big mutual funds, index funds and state pension funds, and has not impeded the market for corporate control and corporate accountability (in fact, a much bigger problem has been legal shackles on hostile takeovers).

Passive means passive: Holders don't determine share prices -- buyers and sellers do, including short sellers. And Citi's management, if it can't make its business model work, won't find Abu Dhabi any proof against a falling share price and harsh pressure from the markets to change direction.

My Rise of the Uncorporation contrasts passive structures like mutual funds with what I call the partnership-type structures, including private equity, that can have a real and beneficial impact on governance.

I suspect that Congress won't do anything more than make noise about sovereign wealth investors precisely because they're incumbent managers' best friend. 

Regulation vs. competition in mutual funds

As I have pointed out before (e.g., here and here), calls for more mutual fund regulation run up against the daunting fact that mutual funds are essentially products that compete in a very robust and extensive market. Now there is some heavy-duty support for that proposition, John Coates and Glenn Hubbard, Competition in the Mutual Fund Industry. Here's the abstract:

Since 1960 the mutual fund industry has grown from 160 funds and $18 billion in assets under management to over 8,000 funds with $10.4 trillion in assets. Yet critics - including Yale Chief Investment Officer David Swensen, Vanguard founder Jack Bogle, and New York Governor Eliot Spitzer - call for more fund regulation, claiming that competition has not protected investors from excessive fees. Starting in 2003, the number of class action suits against fund advisors increased sharply, and, consistent with critics' views, some courts have excluded or treated skeptically evidence of competition and comparable fees of other funds. Skepticism about fund competition dates to the 1960s, when the SEC accepted the view that market forces fail to constrain advisory fees, in part because fund boards rarely fire advisors. In this article, we show that economic theory, empirical evidence, and careful analysis of the laws and institutions that shape mutual funds refute this view. Fund critics overlook the most salient characteristic of a mutual fund: redeemable shares. While boards rarely fire advisors, fund investors may fire advisors at any time by redeeming shares and switching into other investments. Industry concentration is low, new entry is common, barriers to entry are low, and empirical studies - including new evidence presented in this article - show higher advisory fees significantly reduce fund market shares, and so constrain fees. Fund performance is consistent with competition exerting a strong disciplinary force on funds and fees. Our findings lead us to reject the critics' views in favor of the legal framework established by §36(b) of the Investment Company Act and the lead case interpreting that law (the Gartenberg decision), while suggesting Gartenberg is best interpreted to allow the introduction of evidence regarding competition between funds.

Steel on hedge funds

I was with Professor B at a Manhattan Institute event yesterday. Steve, Nicole Gelinas, the Manhattan Institute’s Jim Copland and I discussed SOX.  There was another panel, with Christine Edwards, Michael Perino, Walter Olson and Peter Wallison, discussing litigation.

I had to duck out to catch a flight before the lunch speech by Treasury Undersecretary Robert Steel. Sorry I missed it because, based on this Bloomberg report, it sounded good:

Robert Steel, the U.S. Treasury's top finance official, said he opposes stricter regulation of hedge funds because it would increase risks by suggesting the government has given their investments an "all-clear.'' Steel, the Treasury undersecretary for domestic finance, also said it would be costly and impossible to train enough people to keep tabs on some 8,000 hedge funds. "I don't like the moral hazard of communicating a government all-clear,'' Steel said at a conference hosted by the Manhattan Institute in New York today. The risk is that regulation "communicates confidence in a product that is riskier than normal investors should get involved in,'' he said.

Sounds right. In fact, I made a similar point about SOX in my initial SOX article (at 52-53 in the published version, footnotes omitted):

[E]ven if lack of confidence is keeping investors out of the market, it is not clear that regulation should bring them back in unless it actually justifies greater confidence. The Sarbanes-Oxley Act may justify little confidence because it makes only incremental changes in prior law. Corporate frauds arguably were facilitated because there was too much investor confidence, as indicated by investors' willingness to ignore what the market knew about questionable accounting and to not question firms' extravagant claims about unproven business plans. Overselling regulation might perpetuate this misjudgment and mislead investors back into the same complacency that contributed to the recent frauds.

Publicly held hedge funds: the new Hotel California?

The WSJ discusses a not clearly welcome new development – exchange-listed hedge funds.

Why might this be a problem? Because as the story points out, these new animals forfeit many of the advantages of real hedge funds. They have to subject themselves to regulatory scrutiny, which will certainly make them sluggish. And even more important their managers will be subject to the weaker discipline of the standard corporate model.

As I argue in my soon-to-be released paper presented at the AALS, hedge funds are supposed to be part of the response to weak corporate governance.  Public ownership may make them part of the problem. Traditional hedge and private equity fund managers are owners themselves, easing the separation of ownership and control. As public corporation managers, they will face all of the regulation and scrutiny of pay that's helping turn corporate managers into bureaucrats.

Real hedge and private equity fund managers also have obligations to make distributions to owners that subject them to the hard-core discipline of the capital markets. Part of the reason for the publicly traded funds is to create "permanent" capital, thus to remove this discipline. (In fact, the new development may reflect harder times for raising new private equity money. So it's time to bring in the suckers.)

Of course owners of the new publicly traded hedge funds will be able to get out by selling on the market. But since the owners will be subject to the "capital lock-in" of the typical corporation, sale prices will reflect agency costs. Like guests at the Hotel California, they can check out, but they don't really leave.

This is all part of the evolution of business forms. Nobody can predict where this will end up. Right now I'm skeptical.  But unlike your typical politician or business journalist, I don't think my skepticism is a cause for regulation.